5 years later: Lessons from the crash

Lehman Brothers implodes

Five years ago, you witnessed the worst panic unfold on Wall Street since the Great Depression.

As home prices fell and mortgage-backed securities soured, the pillars of the nation’s financial system — from investment banks led by Lehman Brothers to thrifts such as Washington Mutual to the insurer AIG to mortgage giants Fannie Mae and Freddie Mac — toppled like dominoes.

Among the eventual losses: 5,000 points on the Dow Jones industrial average, $7 trillion in wealth, and, of course, your faith in the financial system.

Fast-forward to the present, and the Dow has returned to pre-crisis levels and is back to setting new highs.

As you look at the key events that transpired since Lehman’s collapse, you’ll find lessons big and small that are as relevant as ever. It turns out that for better or worse, things haven’t changed nearly as much since the crisis as you might have expected.

On the slides that follow is a year-by-year look at key events in the financial crisis, with the main lesson to take from each of them.

Lesson 1: Don’t bank on one sector

September 15, 2008: The turmoil after Lehman’s collapse was different — and more frightening — than the tech crash in 2000.

This time the stocks that took the biggest hits weren’t shares of profitless startups. They were financial titans — some more than a century old — that produced a third of the market’s profits and dividends. No wonder these blue chips were fixtures in many retirement portfolios.

The love affair is clearly over. Or is it? Financials have been the market’s best performers since September 2011, posting annualized gains of 39%.

As a result, bank stocks, which made up less than 9% of the S&P 500 in 2009, based on total stock market value, now represent more than 17% of the broad market. That means they’re probably among the biggest holdings in your stock mutual funds and ETFs.

To limit further exposure, stick with funds that focus on pristine balance sheets and consistent earnings, such as MONEY 50 fund Jensen Quality Growth JENSEN QUALITY GROWTH FUND IJENIX0.05%, where financials make up less than 4% of assets.

More takeaways from 2008

October 16: In a month when investors yank $71 billion from equity funds, Warren Buffett says buy U.S. stocks.The moral: You have to be willing to go against the crowd, and fund flows are a good contrarian indicator.

December 11: Bernard Madoff is arrested in largest Ponzi scheme and financial fraud ever. The moral: Investments that seem too good to be true are. Madoff also demonstrated the risk of letting a single fund manager or financial adviser oversee your entire portfolio.

Lesson 2: Buy and hold works – eventually

March 9, 2009: When the Dow fell to 6547 that day, stocks had already lost more than half their value. And equities wouldn’t fully recover until 2013. So it may seem that investors who pulled $25 billion out of stock funds in March and $240 billion — plowing that money into bonds — over the next three years were on the right track. They weren’t.

March 2009 marked the start of a bull market that saw stocks return 174% so far, vs. 25% for bonds.

Had you simply hung on to a basic 70% equity/30% bond strategy from Sept. 1, 2008 — when things started to get scary — you’d have earned more than 7.5% a year. That’s not far off the 9% historical annual return for this mix over five-year stretches since 1926. Of course, you’d have earned that only by staying the course.

More takeaways from 2009

March 31: The price/earnings ratio for stocks, based on 10 years of averaged profits, falls to a generation-low 13.3. The moral: The price you pay for stocks is the single biggest determinant of future returns. Since March 2009, the S&P 500 has gained 22% annually.

October: U.S. unemployment rate peaks at 10%.The moral: Emergencies don’t happen just to other people. Set aside six months of expenses in cash — a year’s worth if you’re over 50, as your job hunt will take longer than a 30-year-old’s.

Lesson 3: Reaching for yield can fail

January 11, 2010: When stocks fall, the stability of cash can cushion the blow. Yet things don’t necessarily work out that way.

Just ask shareholders of Schwab YieldPlus. This so-called ultrashort bond fund — which was marketed as a cash alternative, though it really wasn’t one — fell 35% in 2008 when the mortgage securities that provided the “plus” in the fund’s name turned out to be riskier than thought. (Schwab settled the charges in January 2011 but did not admit wrongdoing.)

Before that, there was the Reserve Fund, the first money fund in 14 years to lose value in part because it tried to boost payouts by holding some Lehman debt.

It makes no sense to take risks with your rainy-day savings, a lesson that’s worth remembering today. Since early 2009, investors have poured $73 billion into floating-rate bond funds, which buy short bank loans that offer higher payouts than basic cash. And $33 billion has gone back into ultrashort bond funds.

More takeaways from 2010

May 6:The Dow mysteriously drops 1,000 points in a “flash crash” blamed on computer trading models. The moral: Rapid-fire programmed trading is yet another reason individuals should just stick with buy and hold.

December 31: Fidelity reports average 401(k) balances have recovered from the financial crisis. The moral: Between December 2007 and December 2010, 401(k) balances rose about 1% annually, while stocks lost close to 3% a year — proving that saving is your most reliable retirement planning tool.

Lesson 4: Diversification works

In 2008, only one type of diversification seemed to pan out: your basic mix of stocks and bonds. Among equities, everything pretty much fell in lockstep.

February 2012: Fast-forward more than three years, when the financial crisis unfolded in a different guise — this time with the debt crisis in Europe. Fear of government defaults peaked in early 2012, with rates on Greek debt reaching 29%.

Diversification worked here, too, but also in a different guise.

While conventional wisdom said investors should flee the continent, European shares wound up beating the world in 2012, returning 20.3%. The year before that, it was U.S. stocks that performed the best (despite Uncle Sam’s fiscal woes). And so far in 2013, Japan is leading, despite having just been in another recession.

Spreading your bets globally eventually pays off, especially given how mercurial equities can be. For investors who are hearing that the U.S. looks like the only promising market these days, this is a clear lesson to heed.

More takeaways from 2011-2012

August 5, 2011: In response to the budget stalemate, S&P strips the U.S. of its AAA credit rating. Ironically, Treasuries post their best week in two years. The moral: U.S. debt remains the world’s safe-haven investment of choice, despite Uncle Sam’s fiscal troubles.

January 31, 2012: Spurred by anemic bond yields, investors pour money into dividend funds, leading to worries of a “dividend bubble.” The moral: While this fear is overblown, it’s a useful reminder that no matter how appealing income-paying shares are, they’re far riskier than bonds.